Traders, analysts and strategists have been stumped by a market paradox in recent weeks: despite earnings that have been off the charts, rising 24% Y/Y (the most since 2010, if largely thanks to Trump’s tax reform), the S&P is still down for the year, after experiencing two brief 10% corrections just the past 4 months after a torrid, melt-up start to 2018.
How come? While many have offered explanations why the market refuses to break out higher, one of the most convincing observations comes from Matt King, who in his latest note points out that it is all about rates, both nominal and real, and how they influence risk assets. That particular interplay is especially notable because as the Citi strategist writes, whereas straight market correlations between both nominal and real yields and risk assets tend to prove unstable, “they can be thought of as following a regular cycle.”
The cycle in question, which is shown below…
… boils down to one thing: competition for investment flows.
King suggests thinking of the 5 steps as follows:
- while risk assets like credit tend to respond positively to early signs of inflation and growth…
- once these give way to a recognition that central banks will have to withdraw stimulus and raise rates …
- manifested in rising real yields, at which point risk-on turns to risk-off…
- This continues until real eventually central banks are forced back into easing…
- Lowering real yields, prompting investment flows to return to risk assets, and eventually completing the cycle by helping to drive optimism about growth again.
Note the critical role central banks play in this cycle: they are the de facto catalyst, whose monetary policy intervention serves to mark the trough in the cycle once risk assets hit the so-called “Fed Put”, whose new strike price under Jay Powell was quantified last week by Deutsche Bank at roughly 2,300-2,400 in the S&P500.
While King admits that the “Real Yield Cycle” is merely a simplification, it does seem to fit relatively well with both credit and equity moves over recent decades, and “would suggest that risk assets will continue to be vulnerable – and that even if yields start falling again, it may well be as part of a flight to quality.”
But whereas the real yield cycle may provide a shorthand approximation of where in the cycle we should be, another paradox emerges when looking at where we are in terms of risk flows.
This is where it gets interesting.
It is no secret that Matt King (and not only) has been increasingly bearish for the past few years, predicated by the threat that is the tapering and eventual reversal in central bank assets. Here, unlike most of the peanut gallery, King who has repeatedly proven that he is one of the best credit strategists on Wall Street, admits that just as central banks were the driver for risk assets to hit all time highs, so their reversal will unleash the next correction/bear market/crash.
And yet, despite repeated warnings, despite the Fed’s balance sheet having shrunk by $100 billion recently, despite a mature credit, business and “real yield” cycle, despite a bevy of geopolitical risks, stocks – both in the US and globally – remain just shy of all time highs.
But maybe not for long.
Going back to the chart of the Real Yield cycle, King plays devil’s advocate, and notes that “it may be argued that we are not yet properly in phase 3, that risk assets are going sideways rather than selling off, and that this phase could persist for a while yet – the standard “late-cycle, not end-cycle” argument.” But, the Citi strategist warns again, “we have argued against this previously, and think subsequent market developments this year have become more, rather than less, ominous.”
Why? A very simple reason.
“Inflows to risk assets have basically stopped.”
As we first pointed out several weeks ago, Citi notes first that foreign buying of US credit – for long a mainstay of market demand – fell to zero in November and has not revived significantly since, either in official numbers or on Citi’s own flows (Figure 5). While there has been some rotation towards Europe in Japanese buying, this has not been nearly enough to offset the reduction in the US; furthermore hopes that this is simply a seasonal lull will dwindle further if there is not a big uptick following Japanese Golden Week.
One simple reason for this, as we explained 2 months ago, is that net of surging dollar funding costs, US Treasuries hedged for the dollar mean that the effective yield on US paper is now lower than both JGBs and Bunds, crippling foreign demand.
In other words, as long as the Fed’s tightening cycle keeps overnight funding costs high (note the failure of Libor-OIS to drop as so many so-called experts predicted would happen), demand for US paper will continue to wane.
But it’s not just flows into credit that have suddenly halted: the same has happened to mutual fund flows.
While the weekly numbers have been volatile, and fixed income has held up better than equities, it looks distinctly as though net buying of risk assets has ground to a halt (bottom left chart). Moreover, the flow across asset classes and geographies has been very consistent with the abovementioned late cycle dynamics: a short-term cycle driven by trailing total returns (bottom right chart), and a longer-term cycle driven by deposit rates. As Citi warns, “both of these are sending increasingly negative signals – all the more so now the YTD return on $ IG has hit -3.5%”, an observation which BofA’s Michael Hartnett noted yesterday to warn that the ECB is now on the verge of quantitative failure.
What is King’s conclusion? Simple (no really): just follow central bank liquidity (all the way down), to wit:
The broader point in all this is that – despite the markets’ confusing gyrations and counter-gyrations in response to the latest earnings beat or Trump tweet – there is a pattern. The enormous influx of central bank liquidity in recent years may not have produced nearly as much inflation as expected in the real economy, but it did produce an abundance of asset price inflation – over and above what should have been expected on the grounds of economic fundamentals alone.
The chart he is referring to is, of course, this one:
… and in just a few months, it will turn negative for the first time since the financial crisis. Hence, point #2:
More than that, to quote Jeremy Stein, it got into “all the cracks”, flowing freely from one asset class to another and one geography to another. Now that the flow of central bank purchases is in decline, and especially that the Fed’s central bank balance sheet is contracting, the risk is that this process runs in reverse, leaving asset prices unsupported and exposing surprising vulnerabilities as money comes back out from different asset classes and geographies.
… while brings us to – what else – another gloomy outlook from the man whose clear, simple explanation of why Lehman should fail one week ahead of the Lehman failure in September 2008 , many say became a self-fulfilling prophecy and indeed led to Lehman’s failure.
So far the shift in this direction has been modest. The ECB and BoJ have still been putting chairs into the game even as the Fed has begun taking them out, and there are times when the music is playing that it’s tempting to overlook the markets’ vulnerabilities. But investors prefer $ chairs to € and ¥ chairs, and even they are accumulating at a slower rate. The signs are there, for those who choose to see them – in rising real yields, in falling inflows, in pockets of stress in global money markets, and in the continuing correlation between market moves and global central bank liquidity.
As more chairs are withdrawn, expect more consensus trades suddenly to come under pressure – and don’t be surprised if more than a few investors find themselves left standing awkwardly as a result.